When someone quotes an interest rate without specifying whether it is real or nominal, they are giving you incomplete information. Nominal rates are what you see on the screen. Real rates are nominal rates minus inflation, and they are what actually determine whether borrowing is expensive or cheap, whether saving is rewarding or punishing, and whether financial conditions are tight or loose.
A nominal Fed funds rate of 5.5% with inflation at 3% means a real rate of roughly 2.5%. That same 5.5% nominal rate with inflation at 5.5% produces a real rate of zero, which is a completely different economic environment. The first scenario is genuinely restrictive. The second is neutral at best.
TIPS provide a market-derived measure of real rates. The 10-year TIPS yield represents what investors demand after adjusting for expected inflation. When real yields are positive and rising, financial conditions are tightening. When they are negative, the market is effectively paying borrowers to take on debt in inflation-adjusted terms, which is about as stimulative as monetary conditions can get.
The crypto market has shown a notable relationship with real yields. Deeply negative real rates coincided with massive crypto rallies. Sharply positive real rates coincided with the crypto bear market. This makes intuitive sense because negative real rates penalize holding cash and incentivize speculative investments, while positive real rates make risk-free savings attractive relative to volatile assets.
For equity valuation, real rates matter through the discount rate. Higher real rates mean future cash flows are worth less today, which compresses valuation multiples. Growth stocks with cash flows weighted far into the future are more sensitive to real rate changes than value stocks with near-term cash flows.
There are different ways to calculate real rates, and they can give different answers. Ex-post real rates use actual realized inflation. Ex-ante real rates use expected inflation. The Fed tends to focus on ex-ante measures because economic decisions are based on expectations, not yet-unknown future outcomes.
The neutral real rate (r-star) is the theoretical rate that neither stimulates nor restricts the economy. Estimating r-star is notoriously difficult, and different models produce different answers. But the concept matters because it determines what level of real rates constitutes tight versus loose policy.
Tracking the real rate across the curve (2-year, 5-year, 10-year TIPS yields) gives you a more complete picture than any single point. When the entire real yield curve is rising, the broad tightening of conditions affects everything from mortgages to corporate bonds to margin lending rates. That kind of comprehensive tightening eventually slows the economy, but the lag can be substantial.